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Tuesday, September 2, 2014

It was a rather inconclusive week in the markets, as we approach the holidays and year-end. For the week, the Dow and S&P500 added about 1%. The Utilities gained 3%, and the Morgan Stanley Cyclical index increased 2%. The Transports and Morgan Stanley Consumer indices were slightly positive. The broader market was quiet, with the small cap Russell 2000 about unchanged and the S&P400 Mid-Cap index up about 1%. The Technology sector was mixed, as the NASDAQ100 and NASDAQ Telecommunications indices added 1%. The Street.com Internet index declined 1%, the Morgan Stanley High Tech index dropped 2%, and the Semiconductors were hit for 4%. The Biotechs were up 2%. The financial stocks generally outperformed, as the Securities Broker/Dealer index increased 2% and the Banks gained 3%. Although bullion surged $7.20, the HUI Gold index was about unchanged. The Credit market definitely caught a bid. For the week, two-year Treasury yields dropped 11 basis points to 1.73%, and five-year yields sank 14 basis points to 2.90%. The 10-year Treasury note saw its yield dip 11 basis points to 3.96%, while long-bond yields declined six basis points to 4.90%. Benchmark Mortgage-back yields dropped 12 basis points and the implied yield on agency futures dipped 14 basis points. The spread on Fannie Mae’s 5 3/8 2011 note narrowed two to 42, while the benchmark 10-year dollar swap spread declined one to 45. The yield on March 3-month Eurodollars declined four basis points to 1.37%. The CRB index gained another 1% (up 24% y-t-d!), while the dollar index declined less than 1%. The obstinate nature of post-Bubble impairment was captured in a Bloomberg headline this week from Tokyo: “All Nippon Shares Fall to the Lowest Level Since at Least 1984.” Broad money supply (M3) was about unchanged last week, as Demand Deposits dropped $20.6 billion and Savings Deposits gained $10.3 billion. Institutional Money Fund deposits added $17.1 billion, while Large Denominated Deposits dropped $11.3 billion. Repurchase Agreements added $6.9 billion. Total Commercial Paper borrowings dropped $14.9 billion last week to $1.34 Trillion. Nonfinancial CP dipped $2.8 billion to $160 billion and financial sector CP declined $12.1 billion to $1.18 Trillion. Asset-backed CP increased $8.5 billion to $722.1 billion. Total Bank Assets surged $124 billion last week to surpass $7 Trillion. Total Bank Assets have jumped $631 billion over the past 34 weeks, 15% annualized. Last week, Bank Credit increased $70 billion, with Securities holdings up $39.9 billion (Treasury&Agency up $19.1 billion and Other up $20.8 billion). Loans and Leases rose $30.3 billion, although Commercial and Industrial loans declined $1.9 billion. Real Estate loans increased $17.2 billion and Security loans added $13 billion. The Third-Quarter OCC (Office of the Comptroller of the Currency) Derivatives Report had total U.S. commercial bank derivative positions increasing $3.1 Trillion, or 25% annualized, to $53.2 Trillion. By Type, Interest Rate contracts expanded at a 28% rate to $45.7 Trillion, while Credit Derivatives surged 66% annualized to $573 billion. Foreign Exchange and “Other” expanded at a 2% rate to $5.8 Trillion and $1.1 Trillion. By Product, “Futures and Forwards” expanded at a 20% pace to $10.8 Trillion and Swaps at a 7% rate to $29.6 Trillion. Curiously, Options expanded at a 79% rate to $12.3 Trillion (Fannie and others purchasing interest-rate protection in the OTC options market?). Little wonder the interest rate markets have been extraordinarily volatile. Not surprisingly, JPMorgan is the largest OTC Options player, with positions doubling over the past year to $4.8 Trillion. Overall, JPMorgan’s total derivative position was up 13% y-o-y to $27 Trillion. The December Federal Reserve Bulletin contains an interesting study, “Mortgage Refinancing in 2001 and Early 2002.” An estimated $131.6 billion of equity was extracted in the refinancing process during the 18-month period 2001 through the first-half of 2002. I will touch upon a few highlights: Forty-five percent of homeowners who refinanced in 2001 and the first half of 2002 extracted equity, compared to about 35% during 1999. The average (mean) extraction jumped from 1999’s $18,240 to $26,723. By dollar amount, 26% of extracted equity was used to Repay Debt, 35% for Home Improvements, 16% for Consumer Expenditures, 11% for Stock Market or Other Financial Investment, 10% Real Estate or Business Investment, and 2% to pay Taxes. Along with Fannie, Freddie Mac had a big November. Freddie’s Total Mortgage Portfolio expanded at an 11.9% rate to $1.28 Trillion, the strongest pace since April. And again consistent with Fannie, Freddie’s mortgage growth was largely confined to its own balance sheet. Freddie’s retained portfolio expanded at a 29% rate, the strongest since February. Combined Fannie and Freddie retained portfolios grew at a 21% rate during November to $1.31 Trillion. This week from Fannie Mae vice president and chief economist David Berson: “A record year for mortgage originations in 2002 is a certainty - we expect a total of $2.5 trillion in originations this year. It will be difficult to hit a new record next year, however, as the modest uptick in mortgage rates that we project will slow refinancing activity. Still, with home sales down by only 1-2 percent and home prices rising by 4-5 percent, purchase originations should set a new record in 2003. Even refinance activity will stay historically strong, especially in the first half of the year, as significant accumulated equity will keep cash-out refinacings robust - and the modest rise in interest rates should slow this part of the market only a bit. Those households that refinance in order to lower their monthly mortgage payments, however, will drop out of the market in larger numbers. Mortgage debt outstanding (MDO) growth has been extremely rapid this year, helped by record home sales, strong home price gains, and cash-out refinancings. We expect that single-family MDO will grow by about 11.5 percent in 2002, the fastest pace since 1988. Moreover, this would be the second consecutive double-digit gain (the first time since 1989). MDO growth is likely to slow next year, however, as home sales slip, home price gains decelerate, and cash out refinancings ebb. Even so, MDO growth should remain at a strong 8.5 percent pace in 2003, keeping it comfortably within our long-term projection of 8-10 percent for this decade.” (Perpetual Mortgage Finance Bubble or The Next Shoe to Drop?) Today from the California Association of Realtors: “The median price of a home in California continued to post dramatic gains last month, and has increased by double digits every month for the past 12 months… The median price of an existing, single-family detached home… during November 2002 was $328,310, a 21.5 percent increase over the $270,210 median for November 2001… The November 2002 median price increased 1.6 percent compared to October 2002.” (Definitely a Next Shoe to Drop in the unfolding post-Bubble California quagmire.) December 18 – Bloomberg: “Wisconsin may sell bonds to raise some of the $2 billion owed to public employee pension funds as the state cuts spending because of a $2.6 billion deficit. Plans for the 19th-largest state and its local governments to sell taxable pension bonds were proposed after Governor-elect Jim Doyle suggested in late November the state take a ‘pension holiday’ to balance its budget, said Dave Mills, deputy director of the Wisconsin Department of Employee Trust Funds.”December 18 – Bloomberg: “The state Financial Control Board, which monitors the finances of New York City, said in a report that ‘much remains to be done’ to fill a budget gap it predicts will be $3.5 billion in the next fiscal year. The board’s estimate of the gap is about $500 million higher than the $3 billion projected by Mayor Michael Bloomberg for the fiscal year starting July 1, 200 3.” California Governor Gray Davis Wednesday projected a $34.8 billion state fiscal deficit for the next 18 months, an alarming 45% of the general fund. Dow Jones (Stan Rosenberg) quoted the vice chairman of Fitch Ratings: “I’m just stunned at how it could go from $21 billion to $35 billion in a month.” The LA Times quoted the Republican leader of the State Assembly: “These numbers go beyond the most dire predictions and projections we were looking at.” The Democrat Senate President Pro Tem was quoted by the Sacramento Bee (John Hill): “It’s a problem of almost insurmountable proportions.” Earlier proposed cuts – including $3.1 billion to schools, $2 billion to health and social services, $1.7 billion for transportation and $1.9 billion for government administration – will be increased. Taxes and fees will be hiked. Yet the state crisis will surely only worsen. The obstinate nature of post-Bubble impairment. I have below quoted extensively from Governor Davis’s news conference. When reading through his comments, please keep in mind our principle that Credit excess and asset-inflation severely (and seductively) affect/distort both the structure of demand and the nature of income growth. Moreover, policymaker fixation on an index of consumer prices not only completely misses the inflationary boom, relative price stability in goods and services encourages a dangerous sanguine view of manifestations such as rising asset prices and surging revenues. Only the eventual bursting of Bubbles uncovers underlying economic and financial maladjustments. Throughout the country and especially in California, an enormous inflationary bulge (particularly from the technology Bubble) stoked government receipts and, consequently, expenditures and future spending plans. But now a collapsing bubble transforms ballooning revenues into ballooning budget deficits. Golden State receipts have sunk all the way back to pre-Bubble levels, while inflationary pressures persist on the expenditure side. Furthermore, despite the Fed and U.S. financial sector’s Herculean effort to re-inflate, divergent inflationary manifestations emerge predominantly in the real estate and healthcare sectors (with disparate affects on the nature of spending and income growth). These inflationary pressures add little to state revenues, while exacerbating wage and other employment cost pressures (and housing prices!). And, importantly, once severe inflationary distortions are imparted onto the system, monetary accommodation/inflation is impotent to provide quick fixes. Instead of impacting consumer prices, contemporary inflationary consequences are primarily of the structural impairment variety, including a dysfunctional financial sector and maladjusted/imbalanced economy. California is an historic “textbook” example of a Bubble economy and we expect little good news going forward. The Fed’s push to sustain Credit inflation only creates additional distortions, and we are left to Ponder the ramifications for the eventual collapse of the Great California Real Estate Bubble. Wednesday night from Governor Davis: “Fifty-one percent ($17.7 billion) of this [deficit] problem is a reduction in revenues based on predictions in our current budget. Thirty-six percent ($12.6 billion) of the problem are the one-time reductions that we used last year to solve that problem. Twelve-point-five percent ($4.5 billion) are increased expenditures… As you well know, we have a very progressive system in this state – 80% of our revenues come from 10% of the tax earners. So, we depend heavily on the well-being of highly compensated Californians. …From 1995 to 2000 these taxpayers experienced an increase in what they were providing state government on the order of about 18% in ’95, ’96, ’97, and ’98, and then it shot up in ’99 to about 25%, and a little higher in 2000. In 2001, they actually dropped down to zero – so there was a dramatic falloff in 2001. And 2002 they are down about 3%... But when you have a very progressive tax system – which basically exempts everyone from taxes making up to $45,000 a year – and depend heavily on the performance of the top ten percent of your wage earners, then you run the risk that, if they do badly, services have to be reduced and there’s not the revenue for other things we’d like to do in government. So, if there is one single problem that has caused this problem, this is it. Another way of looking at it: If you just took people whose incomes exceed a million dollars, and look at the impact they’ve had on state revenues – again going back to ’95 - it was a 46% increase that year in what they contributed to state revenues. ’96 it was a 20% increase, 33% increase in 1997, 21% increase in 1998, 62% increase in 1999, 45% increase in 2000, and a drop off of 47% in 2001… That’s about a 50% drop in the revenues coming into state coffers from the millionaires in one year. There’s another way of looking at it, because capital gains is a big part of the problem. Obviously, people that do well invest their money. Many of their investments are in the stock market. I’ve told you many times that the NASDAQ was at 5,000 in April 2000; it’s now at about 1,400 – it’s a 75 or 80% reduction… Here again, from ‘90 through '95, you have a fairly steady indication of how much money is coming into the coffers of around $20 billion. Then you have a pretty good run up from '95 up through '98 – we’re up to about $50 billion. But you never realize this until after the fact, but you have a spike in 2000 up around $110 billion. 2001 you’re back down to $40 billionish and 2002 will be less…so that’s another way of looking at the same picture. …Even the sales tax – which is very dependable and does not depend on the higher wage earners - has diminished in recent years. Again, from ’98, ’99, you can see a slight trend upward to 2000, and a slight trend down in 2001. And in the end of 2001 a pretty significant [decline and] you’re back to where you were in 1998 or less. And then an actual reduction in 2001 and 2002 from sales tax revenues from retailers and all sorts of taxable transactions... This is usually a very dependable source of revenue. You rarely see the kinds of fluctuations you do with the income tax. But we are seeing a marked reduction… That shows you in a snapshot that while lack of revenue is not the only reason we are confronted with a major shortfall, it is the primary reason; that, plus the expectation that things would get better quicker last year. We had a lot of one-time solutions, and we did it in part because everyone from Alan Greenspan on down was saying, “The economy will recover – it will recover in the spring of 2002. In the worst-case in the summer of 2002, but it will recover.” And so we didn’t want to savage health and welfare programs and knock people off of programs for which they are eligible when we think the economy is going to bounce back that quickly. Now, the finance department has its conference with a number of financial experts and the consensus now is that it will be very unlikely there will be a recovery in 2003 at all and we’ll have to wait until 2004… But now we are faced with a very different situation and you’ll see when I make my budget plan on January 10th, with a very different response.” While not as dire as California, after the first two months of fiscal 2003 the federal deficit has already reached $119 billion. Year-over-year, Total (two-month) Receipts are down 12.1% to $244.6 billion, with Individual Tax Receipts declining 12.1%. Total (two-month) Spending increased 5.1% to $357.7 billion. By major department, National Defense expenditures were up 10.4%, Education & Social Welfare 13%, Health 11.1%, Medicare 13%, and Income Security 12.9%. Interest expense was down 9.7%, while Social Security was up 5.5%. After two months, the ratio of federal revenues to spending is down to 68%, an alarming decline from last year’s 82%. If this ratio does not improve dramatically, California may not be the only government with an “insurmountable” deficit problem. December 16 – Bloomberg: “MBIA Inc., the biggest financial guaranty insurer, may have larger-than-expected losses to write down the value of collateralized debt obligations it guarantees, a Morgan Stanley analyst said. ‘Our biggest concern relates to the mark-to-market losses on collateralized debt obligations’ and the potential deterioration in the credit quality of securities MBIA insures… as of August (MBIA) guaranteed about $66 billion of collateralized debt obligations -- debt backed by a portfolio of secured or unsecured bonds or loans…” This afternoon from Moody’s: “CDO (Collateralized Debt Obligation) exposure to the recently bankrupt Conseco Inc. exceeds US $1.2 billion, Moody’s Investors Service announced today. The agency has been and will continue to assess the extent of CDO portfolio deterioration resulting from the recent Conseco default.” Two of the seventh largest U.S. bankruptices occurred within nine days. The reality that eyebrows were barely raised attests that it has been a truly numbing year of Credit woe. Interestingly, eight of the twelve biggest bankruptcies were filed over the past thirteen months (WorldCom, Enron, Conseco, Global Crossing, UAL, Adelphia, Kmart, and NTL). Conseco’s list of Unsecured Creditors is headed by a $1.49 billion bank loan owed to Bank of America. Further down the list are the $141.6 million and $129.8 million borrowed from Chase Manhattan and Bank of America for “Director and Officer Loans.” Former GE executive Gary Wendt was paid $53 million for his short and failed tenure. In our analytical framework the near back-to-back bankruptcies of UAL and Conseco highlight the vigor of still unfolding Credit deterioration and systemic vulnerability. These failures definitely add to the deepening woes within the complex CDO, Credit default swap, and asset-backed securities marketplaces. It would not be surprising down the road if we learn Conseco is holding a slug of weak assets. And with a $30 billion managed portfolio of subprime manufactured housing, home equity, and Credit card loans, the company has been no small player in the (“structured finance”) risk market. There are, as well, surely additional Shoes to Drop with respect to the enormous amount of airline travel industry-related debt - from the carriers, to the vehicles and instruments created to finance the aircraft leasing boom, to the airports and municipalities that borrowed aggressively during the Bubble. It is also worth noting the continued deterioration in subprime lending, another key systemic weak link with major ramifications for “structured finance” and the economy. With more than $11 billion of Managed Receivables, things are going from bad to worse at Metris. Receivable growth has come to a grinding halt, with the predictable consequence (as witnessed with Nextcard and others) of escalating losses. The Metris Master Trust (the conduit vehicle for the company’s asset-backed securities) saw November charge-offs jump 205 basis points to 18.61%, while delinquencies rose 53 basis points to 18.24%. Fitch lowered ratings on Metris debt yesterday and Moody’s followed today, with the viability of the company very much in question. Elsewhere, November charge-offs rose between 104 and 219 basis points for three Providian Credit card trusts. Other trust data confirm that most lenders faced rising charge-offs and delinquencies during November, providing strong confirmation of expanding subprime Credit card deterioration. Charge-offs increased 53 basis points at Capital One, despite the addition of new receivables into the trust. One can already see signs that that the abrupt slowdown in growth that is currently unearthing major Credit woes throughout subprime is making its way to Capital One. Developments over the past two weeks have hardened our conviction that expanding Credit deterioration (specifically within structured finance) will increasingly imperil the Credit insurers. This becomes only a more critical issue in the face of rapidly escalating municipal deficits. Municipalities are now embarking on the slippery slope of issuing increasing quantities of debt of deteriorating quality. Worse yet, we expect this issuance flood to hit a marketplace increasingly skeptical of Credit insurance and structured finance. It is helpful to view the confluence of bad news from UAL, Conseco, the subprime lenders, and California in this context. California will be a major issue for muni finance and, later, mortgage finance and systemic stability. For now, we doubt the Governor of California is alone in belatedly recognizing that the optimistic forecasts of stock market and economic recovery were supported by little more than wishful thinking. Last night from Dr. Greenspan: “And, of course, the dramatic gains in information technology have markedly improved the ability of businesses to address festering economic imbalances before they inflict significant damage.” Tell that to Gray Davis and the California legislature! Shallow rose-colored rhetoric and outright denial, as Californians will soon attest, only postpone the day of reckoning while increasing pain and hardship. And as Greenspan again crafts “analysis” to defend what we believe will be his indefensible legacy, we at least welcome Clarification of the Failed Greenspan Doctrine. From Greenspan's latest: “Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess. But the adverse consequences of excessive money growth for financial stability and economic performance provoked a backlash. Central banks were finally pressed to rein in overissuance of money even at the cost of considerable temporary economic disruption… The record of the past twenty years appears to underscore the observation that, although pressures for excess issuance of fiat money are chronic, a prudent monetary policy maintained over a protracted period can contain the forces of inflation… It now appears that we have learned that deflation, as well as inflation, are in the long run monetary phenomena, to extend Milton Friedman’s famous dictum.” "Prudent monetary policy"? Well, we would argue that “the record over the past twenty years” should underscore the danger of uncontrolled Credit systems fueling asset inflation, endemic speculation, Bubbles, and unending boom and bust cycles. Financial deregulation ushered in mushrooming securities markets and the proliferation of non-bank Credit creators. Monetary Processes were forever altered, as were attendant inflationary manifestations. Accordingly, Milton Friedman’s misguided focus on Fed-controlled narrow money as a determinant of inflation or deflation should have been thoroughly discredited and long ago discarded. The analytical focus must instead be directed to the various financial and economic affects and distortions emanating from a diverse array of Credit inflation and speculative impulses. Importantly, one of the manifestations of Credit inflation is heightened domestic and foreign capital investment, thus transforming an index of consumer goods and services prices into a particularly deceiving indicator of systemic monetary stability. And, importantly, over the past two decades we have seen an unprecedented explosion of non-bank Credit creation. Here it has been a rather clear case of easy financial profits directing intensified Credit and speculative excess right to asset markets (Credit market instruments, stocks, real estate, etc.). All one need do is look at the twenty-year explosion of Wall Street and Government-Sponsored Enterprise balance sheets – along with the unprecedented expansion of mortgage-backed securities - as an indication of the propensity for asset-based lending (in the contemporary age of unfettered Credit creation!). We would argue that attention to the issue of government fiat money is much better directed to the critical issue of the gross inflation of financial sector liabilities (the preponderance of contemporary “money” and Credit). The Fed’s focus on the stock market Bubble as THE Bubble is similarly misplaced. In reality – and should, in hindsight, be obvious - the equity Bubble was an offshoot (inflationary manifestation) of endemic Credit inflation. Yet Greenspan continues to espouse the policy of disregarding Credit and speculative excess. Asset Bubbles are to be ignored until they pop, with a focus on quick and aggressive accommodation to “mitigate the fallout [of an asset bubble] when it occurs and, hopefully, ease the transition to the next expansion.” Such experimental central banking is anathema to sound money and stable finance, and will prove an unmitigated disaster. Such policies, as we have already witnessed, only ensure that Credit and speculative excess settle in the enticing mortgage finance arena where uncontrolled Credit creation has the capacity to go to the grossest extremes and inflict its greatest structural damage. Greenspan states, “Among our realistically limited alternatives, dealing aggressively with the aftermath of a bubble appears the most likely to avert long-term damage to the economy.” Ironically, the momentous problem we face today is that the Fed’s aggressive post-tech/equity Bubble accommodation is sowing the seeds for financial and economic collapse. The Mortgage Finance Bubble is expanding exponentially; financial sector leverage is expanding exponentially; derivatives, Credit insurance, default swaps, and other financial guarantees are expanding exponentially; and our debt to foreign-sourced Creditors is growing exponentially. All the while, the quality of this exponential expansion of (non-productive) dollar financial claims is becoming only increasingly suspect. Additionally, we have reached the point where many sectors of the imbalanced and maladjusted economy sputter despite extreme financial excess. Even Credit-induced 4% GDP growth doesn’t do the trick. What rate of GDP expansion would today be necessary to balance the California budget? What rate of money and Credit creation would be required to end state and federal deficits? To thwart bankruptcies? As we have repeatedly attempted to explain, the issue today is not inflation or deflation. The problem is an out of control financial system locked precariously in a Credit and speculative Bubble. And the Fed, Wall Street, and Washington are, incredibly, absolutely determined to perpetuate reckless Credit inflation and the systemic Bubble. The issue is a runaway inflationary expansion of dollar claims. There is, then, little wonder that long-term dollar prospects are nowadays being questioned, while the merits of gold (and other commodities) are seen in a new, glittering light. A bull case for gold can be made today simply by recognizing that the U.S. financial sector and Fed must inflate dollar claims to avoid collapse. Credit Bubbles must inflate or die. Greenspan last night did make the comment, “Cash borrowed in the process of mortgage refinancing…is bound to contract at some point.” Well, we will add that the degree of extreme Credit excess we are experiencing currently in mortgage finance is indeed bound to contract one day. Wild inflationary (speculative) Bubbles invariable do collapse. And as Greenspan stated correctly, “History indicates that bubbles tend to deflate not gradually and linearly but suddenly, unpredictably, and often violently.” One of these days there will be a dramatic shift in the financial and economic landscape. In this regard, think in terms of what Governor Davis faces now that inflated state receipts have collapsed along with the tech Bubble. That the economy and financial system are today struggling in the face of unprecedented mortgage Bubble excess and extreme Credit market speculation does not bode well for the day when the Next Shoe Drops.

It was not an especially comforting week for the rose-colored glasses crowd, with stocks and the dollar faltering as gold moved to five-year highs. For the week, the Dow, S&P500, and Morgan Stanley Consumer indices declined about 2%. The Transports and Morgan Stanley Cyclical indexes dropped 3%, while the Utilities rose 4%. The broader market was also under pressure, with the small cap Russell 2000 and S&P400 Mid-Cap indices declining 2%. The technology sector had a rough go of it, with the NASDAQ100 and Morgan Stanley High tech indices hit for 5%. The Semiconductors dropped 6%, The Street.com Internet index 5%, and the NASDAQ Telecommunications index 7%. The Biotechs were slammed for 5%. The financial stocks generally performed with the broader market, as the Securities Broker/Dealer and Bank indices declined 2%. With bullion up $6.70, the HUI Gold index jumped 10%. With the dollar under pressure, sinking equities didn’t provide their usual kick to Treasury, agency, and mortgage-back prices. We will watch to see if this marks a significant change in market perceptions. For the week, two-year Treasury yields slipped two basis points to 1.85%. Five-year yields dropped five basis points to 3.04%, while ten-year yields dipped two basis points to 4.07%. The long-bond saw its yield decline three basis points to 4.95%. Benchmark mortgage-back yields dipped two basis points, while the implied yield on agency futures dropped four basis points. The spread on Fannie’s 5 3/8% 2011 note narrowed two to 44, while the benchmark 10-year dollar swap spread was about unchanged at 46. The dollar index dropped better than 1%, falling to the lowest level against the euro since January 2000. The CRB index rose to its highest level since 1998, with heating oil at a 20-month high and crude at an eight-week high. Commodity price strength has been broad-based. Broad money supply rose $8.8 billion last week, with (M1 components) Currency up $4.3 billion, Demand Deposits jumping $16.9 billion and other Checkable Deposits up $5.3 billion. (M2 component) Savings Deposits added $3.5 billion, while (M2 component) Retail Money Fund deposits declined $8.0 billion. (M3 component) Institutional Money Fund deposits dropped $18.2 billion, while (M3 component) Repurchase Agreements added $6.5 billion. Commercial paper (CP) declined $7.8 billion last week, with non-financial CP actually increasing $4.0 billion to $163.1 billion. Financial sector CP borrowings dropped $11.8 billion to $1.192 Trillion. Bank Credit declined $6.3 billion last week, with Loans and Leases down $7.1 billion. Commercial and Industrial loans dropped $4.6 billion, Consumer loans dipped $2.7 billion, and Security Loans declined $11.0 billion. The old stalwart, Real Estate Loans, added $13.1 billion. Total Bank Assets dropped $50.7 billion last week after rising $36.2 billion the week before. Third-quarter Current Account data was again dismal. At $127 billion, the deficit was up 39% y-o-y. Total exports were up 1% y-o-y to $312.9 billion, while total imports surged 10% to $426.7 billion. Indicative of how out of whack the trade situation has become, third-quarter goods imports of $298.9 billion were 70% larger than the $175.7 of goods exports. And while our Investment Receipts were down 5% y-o-y at $63.5 billion, Investment Payments were about unchanged at $66.4 billion. It may also be worthwhile to look at prices. Total y-o-y import prices were up 2.4%. By category, Capital Goods prices dropped 2.6%, while Industrial Supplies prices (led by the 35.3% jump in Fuels & Lubricants) increased 15%. Food and Beverage prices were up 5.9% y-o-y, and Autos and Parts nudged up 0.5%. Last week saw 29,477 bankruptcies, down 3% y-o-y. This afternoon New Jersey’s treasurer announced that the state must prepare for a spending freeze, as “Revenue for November falls 6.8% below budget" (business tax and sales tax were 3.7% and 7.4% under estimates). The Mortgage Bankers Association Refi application index dropped 9% last week to the lowest level since July. The Purchase index declined 7%, with the level now only 5% above the year ago level. Fannie Mae’s November Total Business Volume (total mortgage purchases) of $95.6 billion was an all-time record. Fannie’s retained mortgage portfolio expanded at a 16.1% annualized rate, the strongest growth since February. And with “Average Liquid Investments” jumping $12 billion during the month, “Average Total Net Investments” expanded at a 22% annualized rate to $826 billion. Fannie (and we will also assume Freddie Mac) has returned to aggressive balance sheet expansion, with significant GSE money market borrowings likely a factor in recent rapid money supply growth. From Countrywide’s COO Stanford Kurland: “November’s average daily applications totaled $2.2 billion, up 78 percent over last year. This is the third consecutive month that average daily applications were approximately $2 billion. The mortgage loan pipeline increased 6 percent from last month, reaching a record of $55 billion.” Year-over-year, Purchase Fundings were up 61% to $7.7 billion, while Non-purchase (refi) fundings doubled to $24.5 billion. Total “e-Commerce Fundings” rose 75% to $14.3 billion. Home Equity Fundings were up 61% to $1.1 billion, while Sub-prime Fundings jumped 73% to $1.0 billion. Things only get more fascinating by the week. And for those that missed it, we have linked on our home page to a report, Is MBIA Triple A? We will let Gotham Partner’s exceptional research speak for itself. Our macro view holds firm that Credit insurance and the ballooning Credit default swap market provide a critical weakening link for our troubled Credit system. It is worth noting that spreads for “synthetic CDO” structures with Credit default exposure have widened noticeably over the past month. In many ways, we see the current environment as one big confidence game, although a surging gold price and faltering dollar lead us to contemplate that we may be in the late innings. We are increasingly of the mind that the Mortgage Finance Bubble is in the very final stage of terminal reckless excess. As we witnessed with the technology, stock market, and corporate debt Bubbles, ultra-easy money and Credit fuel eventually self-destructive speculation, imbalances, shenanigans and fraud, not to mention the final manic frenzy that entices the last of the remaining buyers. And, once again, the negligent Fed is asleep at the switch. Worse yet, when awake, the Fed apparently likes what it sees, as unprecedented excess runs out of control. We see only conspicuous support for our view that our system has created a Mortgage Finance Monster, with momentous ramifications for the mortgage-back marketplace, the financial system, the U.S. economy and dollar. Apparently, we were not alone in being disturbed by Tuesday’s excellent Wall Street Journal article by Patrick Barta and Queena Sook Kim – Home Buyers’ Down Payments Are Now Paid by Some Builders - reporting on the proliferation of “Down Payment Assistance Programs” (DPAs). For those that read the story, I decided it was worth digging a bit deeper. For those that missed it, let me do a brief summary. The Federal Housing Administration (FHA) a few years back changed its provisions to allow “non-profit” organization gifts to be used as the 3% down payment required of qualifying home buyers. This loophole has spurred the creation of hundreds of “non-profit” groups, many funded by the homebuilders, which have become major providers of downpayments for scores of cash-short homebuyers. And while history tells us rather clearly that borrowers putting no money at risk are quite poor mortgage Credits, the government guarantee (along with an over-liquefied marketplace) allows today’s holders of the rapidly expanding quantities of these mortgages to sleep soundly at night. Still, this is one more extraordinary example of a dangerous mortgage market distortion that is progressive, self-reinforcing and, once unleashed, virtually impossible to reign in. Looking back, it didn’t take long before the idea germinated that these “Non-Profits” could fund their “Gift” pool with “Donations” from interested homebuilders and home sellers. Wow…what incredible profit potential! Cash-strapped renters are afforded the opportunity to rise to the status of proud homeowners. Builders would now enjoy an enlarged pool of prospective buyers, with the not insignificant benefit of having many so anxious at the opportunity of homeownership to be enticed by even the difficult-to-sell and least desirable properties (and they’re willing to pay asking price!). Anxious home sellers, as well, have an enticing avenue to attract a new class of “motivated” buyers. The “Non-Profits” would garner fees to the tune of between $800 and 1% of sales price per transaction. And, not to be overlooked, Wall Street would have more FHA mortgages to sell (and package into Ginnie Mae and other MBS, CDOs and various instruments). What could possibly add more fuel to the unfolding explosion of subprime mortgage lending and the blow-off stage of the Mortgage Finance Bubble? And, of course, what’s good for The American Dream is good for the economy! This is but one more frustrating and recurring Bubble dilemma of seemingly “What’s not to like?” … but eventual collapse. Nehemiah, the “Non-Profit” highlighted by the WSJ, was the first to introduce the Downpayment Assistance Program (DPA). From National Mortgage News: “The non-profit was started in 1994 with $5,000 in seed money out of a small church in Sacramento pastored by the father of the founder…” But the DPA ball didn’t get rolling until 1996, reportedly after Nehemiah’s founder Don Harris received a call from a “frustrated real estate developer” facing difficulties selling foreclosed townhouses from a recently purchased complex. According to the American Banker (Erick Bergquist), “The conversation got Mr. Harris, who is also a real estate lawyer, wondering: What if he could help get people into homes through down payment donations, or gifts, from private industry? After researching federal law, he found a mechanism that lets charitable organizations make such gifts.” From the December 2001 Dallas Business Journal: “…The biggest challenge is convincing buyers and real estate agents that Nehemiah is for real. ‘They think it’s a scam, that it’s too good to be true… Here you have the government, a faith-based group and industry all coming together to do good. It’s an ideal situation, but it doesn’t happen very often.’ Last week, Harris’ Sacramento congregation…dedicated its new $12 million (1,000 seat) mixed-use development, funded completely by the Nehemiah program it inspired.” The entrepreneur Mr. Harris has since moved on to real estate development, now partnering with Nehemiah. Since its founding, Nehemiah has gifted downpayments for as many as 180,000 (another source recently had the number at 130,000) mortgages valued in excess of $13 billion (as of July). It did not take Harris or others long to recognize that this government loophole afforded an extraordinary Big Business opportunity, and to state that these programs have proliferated is an understatement. From the Salt Lake City Tribune (Lesley Mitchell): “Each program operates a little differently, but all are designed to help buyers find a way around a federal law that prohibits sellers from providing down payments to buyers.” From Mortgage Banking, December 2002: “In a conversation with this columnist (Neil J Morse) at the MBA Annual Convention, (Nehemiah’s president) Syphax said the program’s founding philosophy has been widely embraced. ‘We went from being heretics to being imitated,’ said Syphax, referring to low- and no-down-payment financing programs now commonly offered by Fannie Mae, Freddie Mac and major lenders. However, Syphax said, there are still ‘pockets of opposition to our purpose’ from those ‘who continue to believe that if a prospective borrower does not have sufficient funds for a down payment, they must not be quite ready to own.’ According to Syphax, the issue boils down to ‘how much risk society is willing to take on to build its urban centers.’” Back in May, “The Federal Housing Finance Board…appointed Scott C Syphax, President and CEO of the Nehemiah Corporation of California, to the Board of Directors of the Federal Home Loan Bank of San Francisco.” While data is sparse, the best I can gather is that the FHA insures about 1.4 million mortgages annually. Some in the industry believe that as many as 20% of new FHA loans are now using various DPA programs. So, taking 280,000 loans at, let’s say, an average of $150,000 (this is likely too conservative), comes up with $42 billion of new DPA mortgages each year. Big Business, indeed, as the taxpayer and the integrity of the mortgage marketplace absorb the considerable risk. Though it appears these programs are increasingly assisting conventional mortgage borrowers in supplementing required minimal (3% in the case of Fannie, Freddie and others) downpayments. From a July 2001 Bloomberg story: “Wells Fargo, the No. 3 U.S. mortgage lender, says it uses about 600 different down-payment help programs. ‘It’s an extremely important avenue for us to get mortgage volume and also to reach consumers who wouldn’t have been able to afford a home,’ said… a vice president at Wells Fargo.” Also from the article: “Dan Kossak, a 31-year-old pharmaceutical salesman in Atlanta, was able to buy a $192,000 home in December and avoided making the 3 percent down payment out of his own pocket by using Nehemiah… ‘I didn’t want to be house poor,’ he said.” The Department of Housing and Urban Development (HUD) recognized early on that it was facing a problem. Back in September of 1999, HUD expressed concerns that the FHA insurance fund was increasingly exposed to the risky lending and inflated prices the DPA programs were fostering. HUD proposed a rule to prohibit borrowers under the FHA program from using downpayment gifts provided “directly or indirectly” by builders and sellers. But HUD withdrew its proposal a few months later after pressure from Nehemiah and others. It was then off to the races, with the number of new organizations multiplying rapidly. The established groups moved ahead with more creative DPA programs for the high-end. This past January Nehemiah formed a “strategic alliance” with Homebuilders Financial Network (HFN), a group associated (it creates and manages in-house builder mortgage operations) with “member builders throughout the nation which sell in excess of $5 billion of new homes annually.” “Yearning for a brand, spanking new home but don’t have the downpayment?” “The philosophy behind HFN is to provide services to builders that will increase the home builder’s control over the mortgage loan process, provide ease of 'one stop shopping' for the home buyer…” From National Mortgage News: “Under the agreement, the Nehemiah Corp. will offer downpayment assistance to cash-starved buyers who have their eyes on houses built by any of the 20 builders throughout the nation… Nehemiah will provide the seed money in the form of a grant that need not be paid back by the buyer. But the funds will come from the builder as a charitable gift to Nehemiah.” The CFO of HFN was quoted by National Mortgage News: “Downpayment assistance has become a huge aspect of our business…” and “downpayments for as many as 25% of the mortgages his company originates on behalf of its builder-clients come from grants from nonprofits such as Nehemiah.” The head of Nehemiah stated, “The users of the Nehemiah Program now will have access to thousands of new homes across the country.” HFN has relationships with Beazer Homes, Schuler, Dominion, Dura and others. Then in May, “Fidelity National Financial, Inc. the nation’s largest provider of title insurance and real estate related products and services, announced the purchase of a 75% interest in Homebuilder Financial Network…” DPA is both a Big and a growth Business. Meanwhile, Nehemiah and the Copycats have been aggressively expanding beyond traditional DPA programs for FHA qualified borrowers. Notably sophisticated and created for those borrowing above FHA lending limits, Nehemiah has created “The Conventional Program”. “This product combines a first mortgage and a second mortgage which can be applied toward a downpayment and closing costs that is wrapped together and serviced on a single coupon. Specifically, the loan combines a 97% loan-to-value (LTV) first mortgage with a 5% LTV second mortgage to create a 102% loan with a maximum combined mortgage amount of $316,200.” A structure only Wall Street could conceive and love... “Developed jointly with First Nationwide (now owned by Citigroup) and Radian Guaranty, Inc. (mortgage insurer and joint owner - with MGIC - of C-BASS subprime mortgage-back conduit operator!), The Nehemiah Conventional Loan Program is one of the most innovative high loan-to-value products on the market.” The “Conventional Program” does require buyers to put 1% of their own money toward the purchase price, which recalls the reference to “one percent down payment loans” made a couple months back by Fannie Mae’s vice chairman. But with the influx of new players, competition is increasingly tough and the established players – understandably – are getting nervous. Origination News in February quoted the president of Nehemiah: “Many of the programs out there don’t have the long-term concerns we have. They’re more a mechanism to drive the transaction…” (We stumbled across one program that “promoted its Down Payment Assistance Program that enables real estate agents to close more deals and sell more homes.”). And a representative from Neighborhood Gold, a major DPA provider, worries that similar organizations “don’t really give a darn” and “are acting unethically, if not illegally.” This past September a group of DPA providers formed the Homeownership Alliance of Non-profit Downpayment Providers (HAND). “HAND is addressing the downpayment problem in response to President Bush’s statement that it is ‘the single greatest hurdle to homeownership.’” With today’s WSJ article - Rising Home Prices Cast Appraisers In a Harsh Light - in mind, it is worth highlighting a brief excerpt from the trade group’s Downpayment Alliance News: “A new HUD plan to link appraisers with foreclosures on FHA loans has energized the appraisal profession to set up a coalition to defeat the idea.” One important aspect of builder/seller funding of downpayments through these DPA programs is that transaction prices are grossed up in excess of true market prices. How this is impacting appraisals for refis and home-equity loans around the country is unclear. But what is clear is that HAND and the Copycats will be preparing to defeat any opposition to their handsomely profitable “Non-Profit” enterprises. The following were extracted from the various websites of HAND members: Neighborhood Gold (formed in 1999, nonprofit status April 2000): “From Bank of America to Wells Fargo, we work with some of the largest lenders in the nation. We’ve earned their trust because we’ve never held up funds and we’ve made the process simpler than ever before. You just fill out the one-page application online or fax it in and Neighborhood Gold takes care of the rest.” GMAC reportedly also uses Neighborhood Gold. And the site provides the capacity to type in an area code and receive a list of local homes participating in Neighborhood Gold DPA programs (in my case, 135 properties were available). “The Genesis Program is a National Down Payment Assistance Program that provides homebuyers with FREE GIFT MONEY to use towards the downpayment, closing costs, and other funds needed to purchase a home. Genesis will gift up to $22,500.” The Genesis program is reportedly “certified by some of the nation’s largest lenders, including Wells Fargo, Countrywide and J.P. Morgan Chase.” From CDS Grants: “Operation ‘House a Million’ is moving ahead as scheduled. The program is targeting one million renters across the United States who should be able to purchase a home. Many of these people will qualify for a mortgage; they may just need a little help. Too many people wrongly disqualify themselves for homeownership. Our in-depth education on credit, debt and proper spending management will prepare these individuals and families for entry into the home market. When the obstacle is money for a down payment, our HomeGrants Program is able to provide the needed funds. HomeGrants can be used for down payment and closing costs. CDS is currently aligning lenders, in targeted areas, to service those that will qualify for a home purchase. Direct mail, radio and TV appearances are being used to “House a Million”!” A “House a Million” event is scheduled for next May in Las Vegas. From Homebuyers Assistance Foundation: “After looking at the government sponsored down payment assistance programs, the Foundation discovered that the income limits placed on these programs excluded many prospective purchasers. We made the decision to help this segment of potential purchasers by forming a ‘non-government’ down payment assistance program in 1995; and HBAF received its IRS 501(c)(3)determination letter on our program in May 1997. Approvals from FHA, FannieMae, FreddieMac and GinnieMae soon followed in the summer of 1997. Today the Home Buyers Assistance Foundation provides financial assistance through a Gift for the down payment or a Gift for discount points, closing costs, or prepaids. This gift is not repayable. Several organizations began using the achievements the Foundation pioneered in the field of ‘non-government’ down payment assistance.” “Often buyers simply prefer not to prematurely cash in their CD’s or mutual funds, stocks, etc. Instead, they now have the option of accessing Newsong’s pool of funds to ease the burden and maintain their financial stability. In any case, there are no income restrictions or price ceilings for Newsong funding. Buyers who are approved for their loans are automatically eligible to receive up to $25,000. Requests for larger gifts are considered on a case-by-case basis. Buyers typically access around $5,000-$15,000 from the Newsong fund.” Recently established in Oregon, “The Dreamhouse Fund is currently seeking independent sales and marketing representation in all areas of the United States.” Founded in 1999, AmeriDream is one of the more intriguing “Non-Profit” DPA players. Before HUD put an end to the practice, it was common for this group to “gift” money (in excess of required downpayments) that allowed problem borrowers to pay down debt – and thus meet minimum lender requirements. Today, “More than 4,000 homebuyers a month purchase their own homes using The AmeriDream Downpayment Gift Program, which provides down payment assistance of up to five percent or more of the home’s price.” AmeriDream has quickly developed into very Big Business. The group provided 50,000 downpayments last year, and with fees of .75% of a home’s sale price, we’re talking serious money. AmeriDream achieved $146.5 million of “total operating revenue and other support” during 2001, up from 2000’s $36 million. “…AmeriDream Charity constantly seeks ways to make homeownership an obtainable goal for more families. Based on feedback from its many lender, builder and Realtor participants, AmeriDream recognized a need to bring more creative loan products and secondary market solutions to the marketplace. The best vehicle to address these needs was to create and help fund CRA Group. (Formerly known as Valao Mortgage). CRA (Community Reinvestment Acceptance) Group is an affiliate of AmeriDream, but is a stand-alone, for-profit entity.” Monday from National Mortgage News: “Community Reinvestment Acceptance Group LLC has partnered with downpayment assistance provider The AmeriDream Charity Inc. in launching ADC’s S-200 Program. ‘We have enrolled three national lending institutions into the program, and they have already begun to offer the ADC S-200 Program to their customers,’ said Ned Perry, president and CEO of CRA Group. ‘CRA Group develops innovative mortgage products and secondary executions that support lenders’ affordable housing and Community Reinvestment Act lending activities.’ He noted that the partnership allows CRA Group to leverage AmeriDream’s expertise and downpayment assistance resources. Through its S-200 Program, AmeriDream grants homebuyers 3% of the purchase price of a home toward downpayment or closing costs. CRA Group pledges to provide an efficient FHA mortgage execution for lenders and charges almost 50% of the service fee normally assumed by a homebuilder or other seller when using a downpayment assistance program…” Well, well, looks to us like a rather clever maneuver to shift the millions (and growing) of fee income from the “non-profit charity” to the “for-profit entity.” It’s rather obvious that this entire situation is out of control - a not insignificant aspect of the Great Mortgage Finance Bubble. It is also clear that it will be quite difficult to do anything about it. There is the “American Dream” issue, the minorities issue, the Wall Street issue, the economy issue, and the Credit Bubble issue. The only issues that don’t seem to count for much are sound money and a stable financial system and economy. From National Mortgage News, December 2002 (Brian Collins): “The Department of Housing and Urban Development’s Inspector General (IG) is raising concerns again that the Nehemiah downpayment gift assistance program and other nonprofits like it are taking a toll on the performance of the Federal Housing Administration single-family program. In an update of a previous audit of Nehemiah-assisted loans, the HUD IG found the default rate had quadrupled from 4.6% in October 1999 to 19.42% in February 2002. ‘Allowing the continuation of seller-derived downpayments puts the FHA insurance fund at a greater risk and may result in higher mortgage insurance premiums to the detriment of homebuyers not receiving this type of assistance,’ the IG report says... In a March 2000 audit report, the HUD IG recommended a prohibition on home sellers and builders contributing to DPAs. The IG basically took the position that the seller-derived gifts are illegal... But the proposal ran into opposition from Nehemiah and others and HUD eventually withdrew it…” Quoting Bill Apgar, former FHA commissioner and currently with Harvard University’s Joint Center for Housing Studies: “‘When we were pushing reform ideas two year ago, there was a chance to get some control over the (DPA) programs.’ But now HUD has to deal with a bigger problem because the loan volumes are higher and ‘you can’t afford to make a mistake.’” There is now no mystery surrounding the recent surge in FHA defaults. There is at the same time no doubt that this is a major festering problem. Like “zero interest and payments” auto finance, DPA has boosted demand and spurred Credit excess. We fear the cost of prolonging the Mortgage Finance Bubble is enormous and rising rapidly. Regrettably, we learned absolutely nothing from the stock market Bubble’s dangerous excesses.

The almost two-month stock market rally hit a speed-bump. For the week, the Dow and S&P500 dropped about 3%. The Transports actually added 1%, while the Utilities dipped 2%. The Morgan Stanley Consumer index declined 1%, while the Morgan Stanley Cyclical index was hit for 4%. The broader market generally outperformed the major indices, with the small cap Russell 2000 and S&P400 Mid-Cap indices dipping 2%. The fledgling technology recovery backtracked, with the NASDAQ100 declining 4%. The Morgan Stanley High Tech index dropped 7% and The Street.com Internet index 6%. The wild and speculative Semiconductors sank 11%. The NASDAQ Telecommunications index declined only 2%. The Biotechs were resilient, with the major index giving up only 1%. The financial stocks were under some pressure, with the Securities Broker/Dealer index dropping 5% and the Bank index 2%. With bullion surging $9.30, the HUI Gold index jumped 9%. The Credit market remains extraordinarily unsettled. For the week, buyers returned to Treasuries, with two-year yields dropping 18 basis points to 1.87%. The five-year saw yields sink 17 basis points to 3.09%, while 10-year yields declined 12 basis points to 4.09%. The long-bond saw its yield dip six basis points to 4.98%. Benchmark mortgage-back yields generally sank 15 basis points, while the implied yield on agency futures dropped 16 basis points. The spread on Fannie’s 5 3/8% 2011 note declined three to 46, while the benchmark 10-year dollar swap spread narrowed 3.5 to 46.5. Corporate spreads began to widen somewhat toward the end of the week. The dollar came under selling pressure, with the dollar index declining about 1% this week. December 6 – Bloomberg: “California must trim $10.2 billion in spending as the most populous U.S. state seeks to eliminate a deficit equal to one-quarter of its budget, Governor Gray Davis said. Davis announced spending cuts over two years, including $3.2 billion from schools and $1.8 billion from road-building accounts. California’s deficit is expected to exceed $21 billion by the end of the next fiscal year...” December 5 – Bloomberg: “Connecticut Governor John Rowland in a televised speech said he plans to raise income taxes on people who make more than $1 million and that he may cut $100 million of aid for cities and towns to help close the state’s $500 million budget deficit. The speech, carried by several Hartford TV stations, comes on the eve of Rowland firing 2,800 state workers, about 6 percent of the state workforce.” December 4 – Bloomberg: “Massachusetts’ budget deficit could exceed $2 billion next year, the worst fiscal crisis since the 1930s, said Eric Kriss, the chief budget officer of governor-elect Mitt Romney” December 3 – Bloomberg: “Illinois’ $12.9 billion of municipal bonds may be downgraded, Moody’s Investors Service said, citing widening budget deficits and rising health care costs.” December 3 - Dow Jones (Christine Richard and David Feldheim): “National Century Financial Enterprises’ default Monday on asset-backed bond payments underscores growing concerns about potential weak spots in the more than $2 trillion asset-backed market (ABS). Market participants say the NCFE fiasco has raised questions about who’s ultimately responsibly for ferreting out fraud in highly complex asset-backed transactions, many of which carry the highest possible rating of triple-A.” An ABS analyst was quoted: “This is not just an example of a deal going bad. This is a call to action for the ABS market so that it doesn’t happen again.” Also from the article: “Moody’s, the only rating agency that has continued to rate NCFE transactions, is reviewing issues it hopes will allow the agency to catch any future NCFE-type situations earlier.” From a Moody’s executive: “We need to see if National Century is an isolated incident, or if there could be problems with other transactions and other asset classes. We are having discussions with trustees to see what they believe is their role in potentially finding these types of misdeeds. Do they have a fiduciary responsibility beyond their administrative role and how will it affect our ratings if they don’t?” From the article: “If trustees aren’t looking behind the numbers, said (the Moody’s exec) it’s possible that ‘we will require an additional party to find potential problems in the transaction or we may require more credit protection in the transaction.’ Moody’s also is looking at the conditions under which non-investment grade rated or unrated companies should be able to issue top-rated debt.” While money is again flowing to the corporate bond market - with spreads having narrowed significantly over the past month or so - there remain unresolved issues in the marketplace. A bankruptcy filing by United Airlines would be a further blow, with UAL bonds, company-related municipal debt, and aircraft leases in a myriad of special purpose vehicles all posing potential problems for “structured finance.” To what extent the vulnerable Credit insurers are exposed is today unclear. As for the ABS marketplace, we continue to believe effects from the likes of NextCard, Conseco, and National Century have yet to be fully felt. We expect Credit conditions to tighten. It is worth noting that widened ABS spreads have been rather sticky in the face of narrowing corporate spreads, with riskier asset classes seeing little in the way of recent improvement. December 4 – PRNewswire: “Residential originators funded a record-breaking $729 billion in home mortgages in the third quarter, according to National Mortgage News… It appears, based on the current run-rate, that mortgage bankers will wind up funding just shy of $2.5 Trillion in home mortgages this year.” (up from last year’s $2.1 Trillion) December 3 – MortgageDaily.com: “Bankruptcy figures broke records – and backs – in the federal courts during the fiscal year 2002, according to the Administrative Office of the U.S. Courts’ quarterly report. The courts’ fiscal year, which ended Sept. 30, saw more bankruptcies than at any other time in history. They totaled 1,547,669, up 7.7% from the 1,437,354 of fiscal year 2001. No new bankruptcy judgeships have been added since 1992, but the caseload has soared 59% in the last decade… The judiciary has requested new bankruptcy judgeships and budget relief, but the matter will not be addressed until Congress returns in January.”December 5 - Inman News Features (Susan Romero): “Thomas Morgan, associate general counsel for the Texas Association of Realtors, concisely sums up the state of the homeowner’s insurance marketplace as many brokers and home buyers see it today: ‘(Insurance) is too expensive and there’s not enough of it.’ Morgan is in a good position to know. Texas for some time has been the poster child state for insurance industry woes that now appear to be spreading across the country. Real estate brokers aren’t yet yelling ‘crisis.’ But practitioners increasingly are reporting that buyers are facing serious and worsening difficulties in obtaining the homeowner’s insurance they need to close their home purchase transactions, comply with mortgage lender requirement for loan funding and protect what is likely their most valuable asset. An inadequate supply of affordable insurance would put the free flow of the housing market itself in jeopardy. The obstacles buyers face in their pursuit of homeowner’s insurance no longer are shaped solely by the location of the home or the local area’s predisposition to natural disasters. Instead, insurers are citing a wide variety of reasons for cutting coverage and raising premiums, experts say.” December 3 - American Banker (Tommy Fernandez): “In the latest move by a government-sponsored loan buyer to firm up relationships with smaller lenders, Freddie Mac has allied itself with credit unions. Freddie will offer favorable pricing as well as access to its technology and advisory staff to members of the Credit Union National Association… The idea is to make the trade group’s 10,000 members – more than 90% of the nation’s credit unions – more competitive in mortgages.” December 5 - American Banker (Tommy Fernandez): “Bank One Corp. and Fannie Mae on Wednesday announced a $12.5 billion loan program in which borrowers can make ‘little or no down payment’ without the usual requirement for mortgage insurance. Over five years, Bank One will make the loans to low and moderate-income homebuyers and then sell the loans to Fannie… The loans will also feature ‘flexible’ credit qualifications, the companies said.” Monday, the ISM Manufacturing index slightly disappointed, with the composite number inching up from October but remaining below 50. Production jumped 5.3 points to 54.6 and Prices remained strong at 55.7. However, New Orders declined one point to 49.9 and Backlog dipped a point to 42.5. Wednesday’s report on Non-Manufacturing conditions was, interestingly, a much different story. The composite index jumped 4.3 points to 57.4, the strongest reading since May. Prices Paid was stuck at 54, while New Orders jumped 7.1 points to 58 (the strongest reading since October 2000!). The eye-opening money supply growth runs unabated. Broad money supply (M3) expanded $20.2 billion last week, and is up $236.5 billion over seven weeks. For the week, Demand and Checkable Deposits increased $7.1 billion, while Savings Deposits dropped $27 billion. Small Time Deposits declined $1.7 billion, as Large Time Deposits gained $3.6 billion. Retail Money Fund deposits declined $3.6 billion. Institutional Money Fund deposits jumped another $21 billion, increasing three-week gains to $131.5 billion. Repurchase Agreements jumped $10 billion and Eurodollars added $3.7 billion. Non-financial Commercial Paper borrowings declined by $1.6 billion to $159 billion. Financial CP borrowings were unchanged at $1.204 Trillion. Total Bank Credit increased $11.7 billion, following last week’s $24.5 billion decline. Loans and Leases expanded $16.5 billion, with Commercial and Industrial loans adding $5.6 billion. Real Estate loans increased $8.2 billion. Bank Securities holdings declined $4.9 billion. Total Bank Assets jumped $53.4 billion, reversing the previous week’s decline of $51.8 billion. In what is developing into an historic monetary expansion, broad money supply (M3) has now jumped $498 billion, or 10% annualized, over the past 32 weeks. It is again worth noting that M3 expanded by $276 billion, or $55 billion annually, during the first five (disinflationary) years of the nineties. Money supply then surged by $2 Trillion (46%), an average of about $400 billion annually, during the second-half of the Roaring Nineties. And then, in less than three years, M3 exploded another $2.15 Trillion (34%), or about $720 billion annually, to today’s $8.53 Trillion. It has taken less than nine years for the money supply to double. Yesterday, the Federal Reserve released the latest Z1- quarterly Flow of Funds (Credit) report. The Great Credit Bubble becomes only more conspicuous in the data by the quarter. Since the beginning of 1998 (the past 19 quarters), total (non-financial and financial) Credit growth has surged $9.7 Trillion, or 62%, to $30.4 Trillion. Total (federal and non-federal) non-financial Credit growth has jumped $5.09 Trillion, or 45%, to $20.3 Trillion. By category, Total Household Borrowings jumped 64% to $8.2 Trillion, while Total Business Borrowings increased 64% to $7.1 Trillion. State and Local Government Borrowings jumped 42% to $1.5 Trillion. Since the beginning of 1998, Financial Sector Credit market borrowings have more than doubled to surpass $10 Trillion. For the third quarter, Total Household debt expanded at an annualized pace of 9.6%, the strongest rate of growth since the 1980s. The Household sector added debt at a record annualized rate of $724 billion. For comparison, 1998 was the first year that Households increased their debt-load by more than $400 billion. During the third quarter, the Federal Government ran up debt at a 7.5% rate, while State and Local Governments borrowed at a 9.7% rate. The Corporate sector borrowed at an annualized rate of 0.2% during the quarter. Over three quarters, Household sector debt expanded at a 9.3% pace, and one has to go back 15 years to beat this rate. The Federal Government has borrowed at an 8.2% rate over nine months, the strongest pace since 1988. The Federal Government’s appetite for debt, though, is more than matched by their State and Local counterparts. State and Local government debt growth of 8.9% was at the strongest pace since 1987. Year-to-date, Corporate sector borrowings have expanded at less than 1%, the weakest performance since 1992. These lending figures illustrate The Anatomy of a Maladjusted Economy. The bursting of the corporate debt Bubble has seen Corporate Borrowings drop to a feeble annualized $10.7 billion during the third quarter, a far cry from the $400 billion borrowed by the sector during 2000. During the 10-year period 1987 to 1996, Corporate Borrowings averaged $122 billion annually. Sector debt growth averaged about 5.3% annually over this period. Corporate borrowings then jumped to $292 billion during 1997 (up from 1996’s $183 billion), or 9.4%, with borrowings averaging $369 billion during the four Corporate Debt Bubble years 1997-2000. The Bubble “blow-off” stage saw Corporate debt expand by 11.6% during 1998, 10.3% in 1999, and 9.5% during 2000. The faltering Bubble then saw Corporate Borrowings drop to $246 billion during 2001 (5.3%), with borrowings running at a paltry annualized pace of $39 billion over this year’s first three quarters (0.8%). As we have witnessed, deflating sectoral Bubbles prove quite problematic. And while economic “output” expanded at a 4% pace during this year’s third quarter in the face of a shuttered corporate debt market, it required heroic 12.8% Household Mortgage Credit growth to do it. It is, however, a sad case of the appeasement of one faltering Bubble having set in motion much more precarious excess in a grander Bubble. During the third quarter, Total Mortgage (household, multi-family, commercial) Credit expanded by $235 billion - a stunning annualized pace of $941 billion (12.4%) to $8.2 Trillion. This was 20% above the previous quarterly lending record set during last year’s second quarter, and we are now on track for a record $826 billion of Total Mortgage lending for 2002 (up 17% and 46% from 2001 and 2000 growth). For the 10-year period 1988-97, Total Mortgage Credit expanded by an average $222 billion annually. The system now accomplishes as much in three months. And after a decade of heady real estate lending (up 75%), Total Mortgage borrowings then jumped to $499 billion during 1998, and averaged $637 billion annually since 1998. Total Mortgage debt actually jumped $3 Trillion, or 58%, in just 19 quarters, a feat previously accomplished over a 13 year period. During the past seven quarters (Mortgage Finance Bubble “blow-off”), borrowings have surged to an annualized pace of $758 billion. Or, from another angle, over the 10-years 1988-97, quarterly Mortgage Borrowings averaged $55.5 billion. Borrowings have ballooned to an average $189 billion during the past seven quarters. This is some kind of Bubble. And for those that missed it, CNBC should have provided a viewer warning announcement for the other night’s “housing is a sound investment” tirade courtesy of Kudlow & Cramer. With Mr. Cramer professing “housing will always be a great investment” and Mr. Kudlow spouting the virtues of the sector’s “wealth creation,” we haven’t seen such fervent propaganda since the heyday of the Internet/technology Bubble. If we’ve learned anything, it’s that when it has reached the point where we are subjected to the old “you’ve gotta own ‘em at any price,” it is time for us buyers to beware (and hide our wallets!). I have never been especially fond of the inflation/deflation debate. Such a one-dimensional perspective may have been reasonable decades ago when economies were production-driven, finance was generally infused into the economy through bank Credit funding investment (“Monetary Processes”), and domestic economic and financial systems were relatively resistant to global forces. But a focus on an “aggregate” price level is inapt in today’s exceedingly complex global economic and financial labyrinth. To manage U.S. monetary policy on the basis of an aggregate goods and services price index is inappropriate and quite dangerous. To disregard Credit excess, endemic speculation, and asset Bubbles is a failure of monetary theory and central bank policy. And to ignore that contemporary Monetary Processes predominantly inject liquidity into the U.S. economy through the financing of asset holdings (real and financial) is to miss the very essence of contemporary economic analysis. Now that the supposed risk of “deflation” is the focus of considerable attention, it has become clearer in my mind that the nature of the discourse only detracts from the key financial and economic issues of our time. Deflation is simply not today the great risk. It may be, sporadically, a symptom of a serious malady, but it is not the illness. The issue is not the pricing of goods and services, nor does it relate in any manner to insufficient aggregate demand. As yesterday’s data confirm, we remain categorically in a period of historic money and Credit inflation. That this exponential rise in dollar claims coincides with our economy’s declining capacity to produce tangible goods should be disconcerting to our foreign creditors, if it is not to our economic community and policymakers. The critical issue of our day remains a runaway Credit system, with the increasingly fragile financial system and maladjusted economy it has effectuated. Dispersed downward pricing pressures are, in many instances, but manifestations of the Credit Bubble disease. You can treat a distressingly feverish individual by throwing him into a bath of ice water, or you can seek professional help in an attempt to identify the underlying illness. Denial is dangerous, and the appropriate course of action may determine life or death. I will at this point interject some data from today’s disappointing employment report. The Goods Producing sector lost another 40,000 jobs during November, increasing eight-month losses to 332,000. That so many producing jobs have been lost in the face of (ultra-easy Credit-induced) booming auto and home sales is further evidence that something is amiss. To those that continue to trumpet the “underlying soundness of the U.S. economy,” we suggest digging deeper. Indeed, 28 straight months of declining employment has reduced the number of manufacturing jobs back to the level from November 1961. Still, those with rose-colored glasses are quick to point out that, overall, employment has increased 174,000 since April. Considering the enormity of Credit excess and the reported increases in “output” during this period, the data suggest ominous portents for the American workforce. We will not celebrate the Service Producing sector’s creation of 506,000 jobs over the past eight months. With the number of Mortgage Brokers up 47,000, Health Services employment increasing 178,000, Education up 92,000, and Government jobs up 158,000, we see instead illumination of The Anatomy of a Maladjusted Economy. Examining in concert the employment backdrop and third-quarter Credit data provide us with valuable insights to the economy’s predicament. Clearly, the issue is not insufficient money and Credit. Systemic excess liquidity has been more than enough to finance unprecedented household borrowings at declining interest rates. Indeed, rampant monetary excess directs liquidity to the services “producing” arena where there remain strong sectoral inflationary biases – healthcare, mortgage finance, education and government. At the same time, the goods producing area suffers from acute global pricing pressures. While created in over-abundance, liquidity avoids the manufacturing sector like the plague. At this point, it is almost incontrovertible that the U.S. manufacturing depression is structural and not cyclical. This is a dollar problem. For now, at least superficially, extreme financial and economic imbalances cause little grief. Although job creation remains tepid, the booming services sector does support 4% “output” growth. But there is an increasingly important catch to the vaunted New Age Economy. The service/consumption-based U.S. system is becoming only more monetary in nature – only progressively dependent on rampant money, Credit, and speculative excess. Granted, the financial sector has thus far more than accomplished a rather historic feat of endless money and Credit creation, but it is worth pondering the ramifications for the fact that Total Mortgage Credit growth accounted for 88% of Total Non-federal Borrowings during the third quarter (versus 1990’s average of 51%). This one ratio provides a striking elucidation of The Anatomy of a Maladjusted Economy. For a moment, let’s allow our imaginations to run a bit wild. Let’s contemplate that we could still be enjoying the luscious fruits of the Great Stock Market Bubble; that is, if somehow everyone could have been convinced not to sell. If only the small investor, institutions, the gargantuan speculating community, foreign players, and the wealthy insiders would have just held tight. Today’s Great Mortgage Finance Bubble is more complex. For it to prosper on to eternity, we must first convince the household sector to never stop borrowing at increasing growth rates. Second, we must persuade the leverage speculating community, institutions, and our foreign-sourced financiers to only accumulate and never sell agency debt and mortgage-backed securities. But even if the concerted efforts of the Fed, the Treasury, and the GSEs remain successful in keeping everyone in the only game in town, there will nonetheless be increasingly problematic inflationary manifestations. At this point, such a scenario appears in the cards. Today, a powerful and entrenched financial infrastructure is determined to perpetuate the Mortgage Finance Bubble. The Fed has done everything possible to accommodate, thus solidify this dysfunctional financial apparatus. While a fraction of new mortgage Credit finances new construction, the vast majority sustains housing inflation and over-consumption (with, dollar for dollar, considerably less tax revenue impact than corporate debt). For the financial system, only more acute fragility is assured by the ballooning of mortgage Credit of increasingly weak quality. The quality of financial sector assets is poised to deteriorate and become only a more critical issue. Yet, at all cost don’t risk letting the Bubble slow; inflate, inflate, will be the mandate. Although the larger the accumulation of speculative positions in this arena, the more precarious the inevitable reversal. Unlike love, speculator infatuation is not forever. Then there is the insoluble dilemma of dimensions. When it comes to sustaining the Great Credit Bubble, size does matter. The Mortgage Finance Bubble was the one sector sufficient to mollify the effects from the bursting NASDAQ and corporate debt Bubbles, but the sheer size of this Credit monster is unmatched and irreplaceable. From the economy's perspective, the perpetual Mortgage Finance Bubble similarly has no match for its capacity to affect economic distortions – both at home and abroad. To perpetuate mortgage finance excess is to perpetuate over-consumption and massive trade deficits. This is, today, a critical point with profound ramifications. Again, this is a major dollar problem. It has been our argument that endless U.S. current account deficits (inflating global dollar balances) were largely responsible for the ballooning global pool of destabilizing “hot money.” This pool of finance has over the years been increasingly funneled into speculative channels, fueling refashioned booms and busts around the globe. Moreover, this speculative pool has, most unfortunately, found comfortable accommodation in our Credit system. Less appreciated is the reality that U.S. exported inflation has been a leading culprit for the over-finance of global goods producing industries. Whether it was Japan in the late eighties, SE Asia during the nineties, or nowadays in China (with its heavy investment from Hong Kong, Taiwan, and elsewhere), the inflating U.S. financial sector has been, either directly or indirectly, an original source for much of the global pool of available finance. It is over-abundant finance that is responsible for manufacturing sector over-investment that now exerts downward pressure on good prices. Yes, China may today be “exporting deflation” in the manufacturing sector, but the root cause can be traced back to the inflationary U.S. Credit Bubble. While not appreciated by the bullish consensus, today’s extraordinary global backdrop increasingly places the U.S. financial sector directly in harm's way. It has no alternative than to perpetuate the Great Mortgage Finance Bubble, but this entails the unending creation of massive amounts of non-productive, volatility-inducing, economy- distorting debt. Regrettably, previous Credit excess has made profitable U.S. productive investment largely a thing of the past. Not only have distorted investment flows throughout Asia created enormous over-capacity, inflating U.S. wages and other costs have priced the U.S. out of the global manufacturing marketplace. And this will prove a rather tough structural sticking point for the inflationists. To sustain a level of household income growth necessary to support inflating (largely mortgage) debt levels only widens the competitive disadvantage of U.S. producers and fosters further manufacturing atrophy. While they don’t realize as much, the inflationists are fighting a losing war – fighting fevers with ice baths. To dream that we will forever enjoy the capacity to trade newly created (electronic) dollar balances (financial sector IOUs) for foreign-produced goods becomes only more fanciful in an era of out of control current account deficits, an acceleration of manufacturing hollowing, a heightened loss of global competitiveness, and, not unimportantly, Fed governor references to “printing presses.” What about the quality of these inflating quantities of financial sector IOUs? We have watched over the past decade repeated episodes of bursting Credit and speculative Bubbles. There are, virtually by “design,” many consequent examples of faltering currencies. Not many have been orderly, and most can be appropriately described as collapses.

Disclaimer:

Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. The Credit Bubble Bulletins are copyrighted. Doug's writings can be reproduced and retransmitted so long as a link to his blog is provided.